Tuesday, 12 July 2016

Thoughts on the effects of Brexit on UK unemployment and the labour market

Earlier today I participated in a plenary panel session of
the Learning & Work Institute’s IntoWork Convention 2016 on the broad subject
of what Brexit might mean for the UK labour market and employment policy. Here
is a write-up of the issues considered during my brief opening comments:

I broke my ankle a month or so before the EU Referendum
vote.

The experience provides a suitable metaphor for Brexit –
initial pain and trauma followed by a prolonged period of hobbling along at
slower than usual pace plus considerable uncertainty about whether in due
course things will ever again be as good as if the break hadn’t happened.

Translated into economic jargon, Brexit is a supply side
shock to the economy with probable negative short-term to medium term demand
side effects on output and at present indeterminate but probably negative effects
on the potential long-term growth rate.

The
short-term – recession and higher unemployment

Looking first at the initial trauma, there is a fair
amount of consensus about the nature if not the exact magnitude of the short-run
economic impact. The initial source of pain is due to a combination of uncertainty
about the future and the associated adverse effect this has on both business
and consumer confidence. Lack of confidence in turn affects willingness to hold
sterling and is also likely to cause borrowing costs to rise if lenders impose
higher risk premiums on loans.

The value of the £ has already suffered a sharp drop,
providing a stimulus to exports but at the same time set to raise import prices
which will eventually hit real household incomes with knock-on effects to
consumer spending.

Alongside this there will at best be a temporary pause in
business investment while businesses assess the progress and type of post-Brexit
institutional arrangements and trade deals negotiated with the EU and other
countries.

It is probable that the combined negative effects on
domestic demand will to some extent be offset by various forms of stimulatory
policy action by the Bank of England. But monetary policy is a blunt instrument
at times when economic confidence is low and might therefore need to be supported
by active fiscal policy intervention of a kind eschewed during the era of
austerity and ‘small government’ ideology that has prevailed since 2010.

The Government has already wisely abandoned the idea of introducing
a contractionary emergency budget of spending cuts and tax hikes and accepted that
it will now take longer than previously intended to eliminate the fiscal
deficit. Whoever is Chancellor of the Exchequer in the incoming May administration
should be wiser still and open to introducing an expansionary budget of tax
cuts and higher targeted public investment once the Office for Budget
Responsibility has had an opportunity to assess the economic and fiscal outlook
in the immediate aftermath of Brexit.

Nonetheless, even with suitable policy interventions, a
sharp slowdown in short-term economic growth is widely thought to be
inevitable, with many economists, myself included, expecting this to include a
period of outright recession – i.e. at least two successive quarters of falling
output – at some point in the next 12 to 18 months.

However, although Brexit amounts to a significant shock
to the UK economy (with compounding knock-on effects to the EU and wider global
economy) the consensus view expects the effect of this ‘home grown’ Brexit
economic downturn to only be around a third as severe as that caused by the global
financial crisis in 2008/9.

As for the short-run impact on the labour market, a crucial
factor will be the effect of Brexit on employer psychology, which might
exaggerate negative short-run decision making on hiring and firing.

Official data already show some sign of a slowdown in
hiring activity in the run-up to the referendum debate, with further
independent evidence suggesting a substantial drop in hiring activity
immediately following the vote to leave.

But despite limited initial reports of employers shifting
either work or staff from the UK to other EU locations, there is nothing as yet
to suggest employers are cutting jobs albeit it is far too early to be sanguine
about this.

Some may recall the aftermath of the £’s ejection from
the European Exchange Rate Mechanism in autumn 1992. Although this in fact provided
a welcome stimulus to the economy, it initially triggered the biggest ever
single quarterly shake-out of jobs since World War II, greater than anything
that occurred in the recessions of the early 1980s, at the start of 1990, or
the end of the 2000s. Such a response is not beyond the realm of possibility in
the next six months.

In this respect, of course, optimists will take comfort
from what happened following the financial crisis of 2008 which saw the fall in
demand for labour diffused between a rise in unemployment, falling or stable
nominal wages compounding the effect of higher price inflation on real wages,
plus increased underemployment and a shift towards insecure work for employees
and self-employed.

As a result, while the degree of economic pain inflicted
on the UK workforce proved as great as economist’s expected, unemployment
peaked at a lower than expected rate, limiting the amount of psychological pain
experienced.

Yet it is perhaps naïve to expect such a relatively
benign outcome for jobs in any post-Brexit recession since some of the parameters
of employer decision making have changed in more recent years.

For example, the Coalition Government substantially relaxed
the law on unfair dismissal, this decision by former Business Secretary Sir
Vince Cable now making it easier and cheaper for employers to fire staff during
economic downturns.

Similarly, the weakness of productivity growth in the
past decade shows that the economy is to some extent ‘overstaffed’ and
potentially vulnerable to a swift bout of restructuring and downsizing.

Moreover, the climate of wage setting may prove different
in a post-Brexit recession, with significantly more workers protected by the
National Living Wage – which puts a limit on downward wage flexibility – and
others perhaps less than willing to undergo a further prolonged period of
voluntary wage restraint.

Overall, therefore my expectation is that the post-Brexit
recession, while less severe than the 2008/9 recession, will be proportionately
less job friendly, pushing the aggregate level of unemployment back above 2
million within the next 2-3 years.

The
long-term – slower real wage growth

It should be stressed that a rise in unemployment of
around 0.5 million would be far from catastrophic when viewed in UK historical
perspective, thus making it more than manageable in policy terms, albeit it
will be important for those with influence over such matters to press the case
for immediate additional investment in both Jobcentre Plus services and welfare
to work programmes.

Assuming programme expenditure is sufficient to prevent a
rise in long-duration unemployment, the labour market will over time adjust to
reduce unemployment to the pre-Brexit rate. In other words, Brexit will not
lead to a permanently higher rate of structural unemployment.

However, it is virtually impossible to assess how long
the adjustment will take, or at present to judge what the job structure and
sustainable level of real wages might look like once the post-Brexit economy
has returned to full employment.

The crucial and as yet unknown factors in this respect are
what post-Brexit trade arrangements will mean for investment, immigration and employment
regulation.

The consensus view of economists at present points either
toward an unfavourable form of Brexit arrangement in terms of access to the EU
single market which lowers the overall volume of trade and investment - dampening
long-term growth in productivity and real wages – or a favourable form of
Brexit arrangement but one that has little impact on immigration, which while
beneficial on average to productivity might also have a dampening effect on
growth in real wages for less skilled workers.

The type of Brexit arrangement secured will also
determine the extent to which the UK is free to set its own regime of
employment regulation.

Given that the UK labour market is already lightly
regulated by the standard of developed economies it seems unlikely that even an
extreme right wing government with free rein would gain popular support for a widespread
bonfire of employment rights, although some watering down of regulations on
matters such as working time and the rights of temporary agency workers might
be feasible. Action on the latter could serve to lower the UK’s rate of
structural unemployment post-Brexit but at the risk of further entrenching
forms of employment practice that already foster a large segment of low-productivity,
low wage and insecure jobs.

Making
the best of a bad break

Views clearly differ on the efficacy of Brexit. It is
possible that the overwhelming majority of economists who worry about the short
and long-term consequences are wrong and that the future for the UK outside the
EU will be one of even greater prosperity.

For the time being, however, I remain firmly on the side
of the pessimists and expect Brexit to heighten the pain of unemployment in the
next few years and from then on limit the improvement in living standards that would
otherwise have been achieved.

A sensible policy response will help ease the pain of
adjustment and help us to cope as best as possible with future challenges, but
this will nonetheless amount to making the best of a bad (and sadly
self-inflicted) break.